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Student loans: Taking away the free ride for colleges

Looking at the rapid growth of student loans and the escalating price of college from a financial perspective, we see a typical interaction of credit expansion and price, quite similar to what happens in a housing bubble or any other bubble. Pushing credit at a sector makes its prices rise. The rising prices, in the cases of both housing and higher education, lead to cries that since the prices are now unaffordable, there has to be more credit. More (and more heavily subsidized) credit the politicians often enough deliver, and the escalation goes on.

This self-reinforcing dynamic is intensified when there are important parties who get cash from the loans for themselves, but have no riskat all when the loans default. In the most recent housing bubble such parties included lenders who promoted and originated but then sold their mortgage loans. In education, the most important risk-free beneficiaries are the colleges themselves, which keep raising their prices, promote the loans, get the cash from the loans, and don’t have to worry about what happens when the loans they promoted subsequently default.

Interacting credit-price expansions inevitably come to face growing defaults. In a recent paper*, the Federal Reserve Bank of New York observes that “the measured delinquency rate on student debt is the highest of any consumer debt product.” This measured rate of student loans 90 days or more past due is 17%–indeed very high delinquency. But, the New York Fed goes on to say, the real or “effective delinquency rate,” which they calculate by comparing 90 day past dues specifically to those student loans where borrowers are being asked to repay, is over 30%!

That 30% is the same as the peak serious delinquency rate of subprime mortgage loans in 2009.

Among the things to be done to improve the student loan-college price spiral is to address the free riders in the student loan sector: namely, the colleges. They should cease to be free riders on other people’s credit risk and credit losses. Here I have one firm recommendation and one further possibility to suggest.

First, the colleges should definitely have “skin in the game” in student loan credit risk, just as the need for “skin in the game” was one of the biggest lessons of the mortgage bubble.

Each college should be financially on the hook for at least 20% of the losses its own defaulting students cause. This would certainly improve what is now a complete mismatch in incentives, and thus improve educational, as well as financial, performance.

A second idea (wittily suggested to me by Arthur Herman of the Hudson Institute) is one which should strongly appeal to everyone on the leftward side of this discussion. It is to have a wealth tax on rich colleges to help fund the cost of student loans.

My version of this idea is that the wealth tax should apply only to the top 1% of college endowments (of course not to the 99%). There are about 2,800 four-year degree granting colleges, so the top 1% would be 28 of them. You could easily guess most of the prestigious names on this list. They represent an “inequality” problem of a severe kind: the top 1% of endowments have 51% of the total college endowment wealth. This is obviously unfair! So as suggested by the current darling of the left, Thomas Piketty, a 5%-10% wealth tax on the assets of this unfairly advantaged 1% might seem about right.

However, in my proposal, a college or university would be exempt from this wealth tax if less than three of its faculty members have publicly argued for higher taxes on the wealthy. But if three or more of its faculty members have promoted more taxes on the wealthy, the tax would apply to that member of the college 1%.

I imagine that with this criterion, all 28, except perhaps the University of Chicago, would be paying. A higher degree of poetic justice would be hard to find.

In any case, the essential conclusion is that the colleges have to stop being free riders which jack up their prices and promote debt, while pushing all the credit risk and losses on the taxpayers.

Discussion: (12 comments)

Why limit the college exposure to 20%? In reality the loan is going to the college–make it liable for any default. They can easily pay for the losses by firing a couple administrators, or reducing the Dean’s salary.

Very bad idea. College is too easy now, your idea will produce “A” grades for enrolling in the class. No show OK. Makes it easier on everybody. Students can go about their “business” and the faculty can carry very large class loads. See UNC for an example, worked well for their sports teams who graduated students who couldn’t read.

I agree with Arthur O. Fifty percent seems better, in my view. That would help with the inflated cost of living outside of the classroom. Of course I would expect colleges to game the system they own to insure graduation numbers improve, but that won’t help them in the long run. If–as with high schools–graduates are incompetent and can’t earn sufficient income to pay back loans that gaming just increases overall costs and only pushes the eventual default down the road. Either way, colleges get skin in the game.

The first idea is much better and much less complicated: ask colleges to co-sign their student loans. Give government grants only to colleges that (a) cosign for at least 25% of the total amount of all the loans of its students, (b) make decision about co-signing based exclusively on student grades, scores and chosen major.

That immediately guarantees that the colleges will be very precise calculating which loans make sense as an investment.

We need to stop adding laws to fix things that can be more easily and directly fixed by subtracting laws. If we subtract the change to the Bankruptcy Code that makes srudent loans undischargeable, then student loans would be treated just like credit cards, which is pretty much what they are.

This re-adjustment back to the historical BK Code would make it much less likely that banks and other lenders would make high five-figure loans to 18-21 year olds to use for college. The market would sort out the rest, with shrinking of college administration payrolls being job one. Tuition would crash as well.

I agree that the Bankruptcy Code should be changed. But, since the Federal Government does most of the lending, it would not affect the amount of loans made, nor the ultimate cost of their write-off to the taxpayers. Making the Colleges responsible for the loan (and I see no reason why it should not be 100%) would cause them to think very carefully about who got the loans, and what the chances of repayment are. This would reduce defaults and write-offs .

A way must be found to break higher education’s chokehold on entry into a good earning life. The life of mind is becoming an increasingly transparent con, as “college is for everyone” turns college into 13th grade.